Friday, July 31, 2015

Seventh Circuit Endorses Use of Blue-Pencil Rule for Non-Competes

More times than not, courts in non-compete disputes confront restrictive covenants that have problems. Sometimes the problems are severe and other times they are revealed through the unique facts of the case, rather than the face of the document.

Yesterday, I spoke at the Annual Meeting of the American Bar Association and gave an update on key issues in non-compete and trade secrets law. One of the issues I discussed was the partial enforcement rule - in other words, how courts handle problems of overbroad covenants in enforcement actions.

Interestingly, the day before my presentation, the Seventh Circuit issued its opinion in Turnell v. CentiMark Corp. (embedded below). That case discussed Pennsylvania law concerning partial enforcement of covenants following an appeal from a preliminary injunction. CentiMark is a leader in a certain type of commercial roofing material used on commercial and industrial buildings. Turnell ran the Chicago District and had multi-state responsibilities.

The district court found that, under Pennsylvania law, Turnell's agreement was overbroad. But, after an evidentiary hearing, it reduced the scope of the agreement and enforced the reasonable parts. In doing so, the court properly found instances of overbreadth that are fairly common: (a) the non-compete banned work in an industry similar to that in which CentiMark engaged, meaning it covered too many products; (b) the non-compete barred sales to even prospective, as opposed to actual, customers; and (c) the geographic scope was vague and reached territories where Turnell was not primarily working.

On appeal, Turnell did not challenge the terms of the injunction and argued the district court should not have wielded the fictional blue-pencil to rewrite the contract. But the Seventh Circuit found that Pennsylvania law allowed the court to use its discretion to fashion an injunction remedy.

During oral argument, the Court was sympathetic to the possible overuse of the blue-pencil rule. And Judge Kanne's clear, insightful opinion reflects the tension and perverse incentives that the rule sometimes creates. Interestingly, the Court stated that "to some extent overbreadth is unavoidable given the imprecision of our language. "Ultimately, however, the Court did not seem persuaded that the terms of Turnell's agreement with CentiMark reflected bad faith or an intentional overreach on the employer's part.

I noted at the ABA Annual Meeting that there are four approaches to partial enforcement of overbroad agreements:

1. The "no modification" or red-line rule, which holds that courts will not modify agreements. Put another way, the covenant must be enforceable as written. Virginia adopts this approach.

2. The strict blue-pencil rule, which provides that courts can excise or eliminate overbroad, severable portions of an agreement. But the court will not add terms or use discretionary powers to modify the covenant. Indiana adheres to the blue-pencil rule.

3. The equitable modification principle, which was at issue in Turnell. This approach trades predictability for flexibility, because a trial judge can in effect become a third-party to the contract and impose terms that appear nowhere in the contract. Ohio adheres to this rule, and so does Illinois, but only in a more cautionary sense (for it can implicate public policy concerns). For instance, had Turnell challenged the Pennsylvania choice-of-law clause, Illinois' public policy may have called on the district to apply more favorable law.

4. The mandatory modification rule, which requires courts to reform agreements if they're overbroad. Texas endorses this rule, but provides that if a court orders a reformation, damages are then not available.

The equitable modification rule is, in many respects, very problematic. And in other cases similar to Turnell, courts have refused any sort modification. The approach often leads to the "right" result from a policy perspective, but it has a damaging collateral effect divorced from the litigation. Attorneys often cannot advise clients as to expected litigation outcomes, because it is very difficult to predict how a court will apply the reformation concept. As a result, many employees forego challenging the agreement altogether because of unpredictability (and their lawyers' hedging).

In light of the Court's recent opinion in Instant Technology (see post below from July 15, 2015), it surprises me that the Court did not mention the importance of predictability and clarity in the law of non-competes. In the end, though, the Court was constrained by Pennsylvania law, which allowed the district court to exercise her discretion and reform Turnell's contract.

Wednesday, July 15, 2015

Seventh Circuit Smartly Avoids Fifield Issue, Disses Illinois Law

In the detritus of Illinois law following the Fifield v. Premier Dealers Services case, one federal case actually appeared to have the potential to reshape how state courts (not to mention an increasing number of lower federal courts) viewed the issue of non-compete consideration for at-will employees.

Instant Technology, LLC v. DiFazio (7th Circuit, Nos. 14-2132 & 14-2243) was one of the diversity cases where the court followed Fifield and endorsed the two-year, bright-line consideration rule, which holds that non-compete/non-solicit covenants are enforceable only if an at-will employee has been employed two years or more. (This, of course, assumes the only consideration offered was employment itself, not something more tangible.) Other diversity cases declined to follow Fifield on the grounds that it did not accurately state the law in Illinois. Those cases have said that if the Illinois Supreme Court were confronted with the issue, it would come out with a different rule than that set forth in Fifield.

Instant Technology was always somewhat of a flimsy candidate for a broad, doctrinal repudiation or endorsement of Fifield, since the case appeared to founder on whether the covenants in the IT staffing business supported a "legitimate business interest." The district court found not, and the Seventh Circuit held that this finding was supported by the evidence. And on that score, Judge Easterbrook's opinion in Instant Technology gave nary a mention of Fifield or the current debate over consideration.

However, at oral argument, the Court discussed Fifield at length. And Judge Easterbrook is not the kind to wilt away and blindly assume the appellate court got it right in Fifield. He would seem to have little trouble excoriating the state court rule if he felt the legal standard was groundless. But his opinion avoided the issue, so we have nothing authoritative from a case that at least held out the possibility of being a game-changer in the consideration debate.

But, not surprisingly, Judge Easterbrook used the opportunity to take a not-so-veiled shot at Illinois law, and in particular the "totality of the circumstances" test from Reliable Fire Equipment Co. v. Arredondo. That case changed the analytical framework for determining how an employer can establish a legitimate business interest to support a non-compete. It discarded the traditional approach - which looked at whether an employer had a near-permanent relationship with clients or whether it sought to protect confidential business information the employee subsequently tried to use - and set forth a rather malleable (cavernous?) test that considered the totality of the facts from the case.

In Instant Technology, the IT staffing firm disputed the district court's analysis and basically said the judge didn't consider "everything," without specifying what it exactly it was that the court missed.

Judge Easterbrook says:

"Making validity turn on 'the totality of the circumstances' - which can't be determined until litigation years after the events - makes it hard to predict which covenants are enforceable. If employers can't predict which covenants courts will enforce, they will not make investments that may depend on covenants' validity, and they will not pay employees higher wages for agreeing to bear potentially costly terms. Both employers and employees may be worse off as a result. Risk-averse employees who hope that their covenants will be unenforceable, but fear that they will be sustained, may linger in jobs they would be happier (and more productive) leaving. But our rule of decision comes from state law. Erie R.R. v. Tompkins, 304 U.S. 64 (1938). Reforming that law, or trying to undermine it, is beyond our remit."

This passage largely pivots off many of the questions Judge David Hamilton asked during oral argument in the case. Judge Hamilton was concerned about the blank-slate landscape of Illinois law (a term used by Instant Technology's counsel) and the lack of apparent predictability in an area that demands it. Predictability and certainty usually arrive in the form of bright-line rules, which (oddly enough) Fifield establishes. As for the broader question of reasonableness, the Seventh Circuit seems to be saying that Illinois employers got what they asked for: flexibility. The price? Often times, disappointment.